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From an IB Economics book (in the microeconomics section):


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The part in blue suggests market failure is the same as allocative inefficiency, but the part in red seems to suggest that market failure is one cause or type of allocative inefficiency.

What is the difference between the two, if any?

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In this context 'market' usually means some allocation mechanism. For example free market, or a market where someone has monopoly power. Allocation of goods and resources can be done in other ways: e.g. you can divide all resources evenly among production processes and all goods evenly between consumers. This will generally result in allocative inefficiency (were all production processes equally important and efficient?). But it is not market failure because there was no market, just an allocator/social planner.

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Allocative inefficiency refers to a situation where good G was bought by buyer B1 ("allocated" to buyer B1) where it would have been more "efficient" if it had been bought by a different buyer B2 ("allocated" to B2 instead of B1). Good G could be producer goods like oil, lumber, plant equipment, or even consumer goods like sandwiches.

In a free market, the only way buyer B1 gets to bid a good G away from buyer B2 is if B1 voluntarily pays more for G than B2 is willing to pay. This means that in a free market G is always allocated "efficiently", because it goes to the highest bidder, ie the bidder who is obtaining the highest "utility" from G at that point in time (that's why he bid highest). In other words, in a free market, goods are always allocated efficiently.

A good G can be allocated inefficiently to B2 instead of B1 if the market is actively prevented by an external force from allowing B1 to bid G away from B2. There are many ways that this happens today:

  • For example, B2 may be subsidized to buy G, which means money is forcibly taken from some tax payers and given to B2, thereby enhancing B2's ability to bid some units of G away from B1. An example of this is when a solar panel manufacturer is subsidized, thereby enhancing his ability to bid away goods from other manufacturers via this mechanism. The subsidy has forcibly disrupted the market and caused allocative inefficiency, as compared to the efficient allocation that would have been provided by the free market.

  • As another example, the regulatory burden imposed on B1 may be higher than that imposed on B2, causing B1 to bleed resources away thereby reducing its ability to bid some units of G away from B2. Say a mom & pop restaurant B1 is forced to comply with a newly imposed food safety regulation, and they spend a higher percentage of their revenue on compliance than would a chain restaurant competitor B2 who already has a compliance department and therefore incurs smaller marginal cost of compliance. In this case, mom & pop restaurant B1 bleeds more compliance cost than chain competitor B2, reducing mom & pop B1's ability to bid goods G away from chain B2. In the free market some units of good G would go to B1, but after forcible imposition of the additional regulatory compliance some of those units instead go to B2. The regulatory burden has disrupted the free market and caused allocative inefficiency compared to the efficient allocation that would have taken place in the free market.

This is why the phrase "market failure" is misleading and incorrect. The free market allocates efficiently, because goods go to the highest bidder. It is "forced market disturbance" that causes allocative inefficiency by disrupting the free market. Therefore, more forced market disturbance means less efficientcy, and less forced market disturbance means more efficiency, with maximum allocative efficiency when the market is free of all forced market disturbances (taxes, regulation, subsidies, red tape, etc.)

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  • $\begingroup$ Your last paragraph seems a little dogmatic. What about adverse selection and efficient levels of public goods? Is there no market failure in these cases? $\endgroup$ – Giskard Aug 4 '16 at 21:27
  • $\begingroup$ Thank you for commenting. "Adverse selection" means one side of the transaction has information that the other side does not have, eg selling a car without disclosing some hidden damage. It is a risk the buyer willingly takes in exchange for a perceived value that compensates for the risk, for example the car is cheaper than buying it new at a dealer. There is no inefficient allocation or market failure. A "public good" is something like freeways or parks, but since they are not a product of the free market, their deficiencies cannot be attributed to any "market failure". $\endgroup$ – user269602 Aug 4 '16 at 23:32
  • $\begingroup$ Thank you for your answer. I know what adverse selection is. It can result in inefficient allocation. I recommend reading Akerlof's "Market for lemons" article. He provides an example where asymmetric information results in utility loss on pg. 492. $\endgroup$ – Giskard Aug 5 '16 at 8:27
  • $\begingroup$ Certainly - I merely provided a quick description of "adverse selection" for readers unfamiliar w the term. Specifically, Akerlof's nice article describes that under info asymmetry, eg a car seller selling a lemon w/o disclosure, the effect is a feedback loop-like drop in avg quality of used cars for sale as lemons drive out good used cars, bec sellers increasingly withhold good used cars as avg prices decline (like Gresham's law). So far so good. But that is not "market failure". Akerlof himself lists various market solutions eg warranties, brand names, certification, etc. (Section IV pg 499) $\endgroup$ – user269602 Aug 5 '16 at 17:06
  • $\begingroup$ Yes, there are possible solutions, but this not what you wrote in your comment. "It is a risk the buyer willingly takes in exchange for a perceived value that compensates for the risk, for example the car is cheaper than buying it new at a dealer. There is no inefficient allocation or market failure." Certainly the original market, the one without the possible solutions you list fails? And in your answer you list "regulation" and "red tape" as "forced market disturbance". But then you list certification as a good thing in your comment. Clarify? $\endgroup$ – Giskard Aug 5 '16 at 18:02

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